Insights

What is a Convertible Note?

Emerging Companies & Venture Capital Practice Briefs

Convertible notes are often the best way for early-stage startups to raise money. They’re usually easier and cheaper to sell than stock, which makes them a good fit for most companies’ first financing.

A convertible note sounds complicated but it’s not. It’s a loan – an investor gives a startup money and the startup promises to pay the investor back after a set period of time.[1] But it’s different from your average loan in that it can convert into the startup’s equity. 

Here’s how you should think about it: investors want to protect against two things, downside risk and upside risk. Downside risk is intuitive – if an investor gives a startup $100,000 then the investor’s downside risk is that the startup goes bankrupt and doesn’t pay them back.[2] This stings, but any early-stage investor should be prepared to lose their investment. Convertible notes are debt, and so the startup must pay them back after a set period of time.

Upside risk comes into play if the opposite happens and the business takes off. A startup investor won’t lose a lot of sleep over downside risk. But the investor’s worst nightmare would be that the investor gives a startup $100,000 and in six months the business takes off, raises additional capital, and then gives the investor its money back (plus some interest for its trouble) and then a year later the startup sells itself to Google for a couple billion dollars. For a startup investor, losing money hurts, but missing out on a home run really, really hurts. That’s why the notes have a conversion provision – if the startup raises a new equity round then the notes will convert into shares of stock in that round, usually at a discount of 10 to 30% to make up for the risk of investing early.

Here are a few pros and cons for startups considering whether a convertible note is the right way for a startup to raise money:

  • Doing a debt financing doesn’t require setting a valuation, which is often a difficult negotiation point for early stage companies. This is useful for growing companies that need a little more time or capital to get to a valuation inflection point (like more data, landing a few major customers or signing a big contract), and it makes the documentation simpler than most equity financings.
  • Note financings are usually cheaper and faster to close than full equity financings, and they typically don’t come with board seats.
  • The downside is that convertible notes are debt instruments with a maturity date, so the startup has to worry about hitting its cash-flow targets or raising more money within a set time period to pay the notes back or trigger a conversion.

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[1] This requirement that the loan be paid back after a set period of time is the biggest difference between a typical convertible note and a Safe Agreement for Future Equity, often called just a “SAFE.”

[2] In general, debt has a repayment priority over equity, so the investor can mitigate some of the non-payment risk by choosing a convertible note.

 

Christopher Poe is an attorney at Wyrick Robbins. His practice focuses on startups and generally helping businesses of all sizes and in all stages of development, from organization to exit. He can alleviate the headaches caused by founding and growing a startup business and scaling it to exit.

The purpose of this brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.